Simpler is Better

What does it mean when the two largest dose CMOs are for sale?
Jan 31, 2007

Jim Miller
Contract dose manufacturing has hundreds of participants, but two have dominated the industry in this decade: Cardinal Health (Dublin, Ohio) and Patheon (Toronto, Canada). With revenues of $1.8 billion, Cardinal Health's Pharmaceutical Technologies and Services (PTS) business unit is by far the industry's largest player, with capabilities spanning a broad array of technologies and dosage forms. At $700 million in revenues, Patheon is the second largest player, and an innovator of now-standard industry strategies such as using development services to drive new commercial manufacturing business.

It is remarkable, therefore, that we enter the new year with both companies facing somewhat uncertain futures. Patheon's board of directors is considering "strategic and financial alternatives," including the possible sale of all or part of the company, in the wake of disappointing financial results and operating problems at several of its facilities. Cardinal Health announced in November that it would sell the PTS business because of disappointing performance and because it is no longer a strategic fit with the corporation's focus on the downstream healthcare supply chain.

The uncertainty surrounding the industry's two highest profile participants has raised concerns among both buyers and sellers of contract manufacturing services about the long-term prospects of the industry and the viability of the CMO business model. After all, if the two biggest companies in the industry can't make a go of it, how can the many smaller CMOs expect to generate profits and attract the capital investment necessary to remain successful?

It would be wrong to jump to conclusions about the entire industry based on the Patheon and PTS experiences. Their acquisition-driven business strategies are unique in the industry, and the challenges of organizational complexity and voracious capital consumption posed by such rapid expansion are not faced by the majority of CMOs, which have chosen a more conservative approach to growth.

Growth through acquisition

The mid-1990s seemed to be an ideal time to build a global contract manufacturing business through acquisitions. Contract manufacturers in the electronics industry were doing it, and their revenues and stock valuations were soaring. Furthermore, the pharmaceutical research and development pipeline seemed full, and there was much talk of the expected growth in outsourcing as both major and small bio/pharmaceutical companies scrambled for more capacity to manufacture the expected flow of new products. That was the environment in which Patheon and Cardinal Health initiated their acquisition programs.

Their earliest deals were right on the mark. Cardinal Health's first acquisitions, including Packaging Coordinators, Inc. and softgel manufacturer R.P. Scherer, remain the core of the PTS business and the principal sources of its revenues and profits. Patheon's initial strategy of acquiring redundant manufacturing facilities from major pharmaceutical companies was both cost-effective and strategic. It was able to buy assets at just a fraction of their replacement value while gaining long-term contracts and building important relationships with some of the largest drug companies.

Nonetheless, later deals ran into problems almost as soon as the ink was dry on the purchase documents. Cardinal Health's 2002 acquisitions of contract analytical laboratory Magellan Laboratories and marketing services provider Boron, Lepore & Associates, Inc. ran into problems soon after their acquisitions due to the loss of major clients. In late 2004, Patheon borrowed heavily and issued equity to acquire Mova Pharmaceuticals (Caguas, Puerto Rico), but an FDA warning letter and a variety of smaller but significant problems quickly eroded profitability and undermined the strategic and economic rationale for doing the deal.

Now, ten years after launching their acquisition-driven strategies, results at PTS and Patheon have been disappointing at best. Cardinal Health has invested $5 billion in building PTS, but its estimated $300 million in earnings before interest, taxes and depreciation mean it is yielding less than an ultrasafe US Treasury security. At Patheon, after nearly $1 billion have been invested, financial performance indicators have fallen short of levels required in its loan agreements, and the company has been forced to consider more radical restructuring moves to ensure its long-term viability.